The Annuity Gorilla In The Room

Over the past decade, one of the hottest retirement products sold by the life insurance industry has been variable annuities. Notoriously fee heavy, they've been steady money spinners for the companies willing to take on the future payment liabilities these schemes entail. Now, it looks like at least one company, Manulife (NYSE:MFC), may be reconsidering the wisdom of having taken on the risk inherent in such arrangements. (Learn more about variable annuities in our article, Getting the Whole Story on Variable Annuities.)Pictures: Eight Ways To Survive A Market Downturn

Blowing the WhistleLast week, Canada's primary stock market regulator, the Ontario Securities Commission, announced that it had reached a preliminary conclusion that Manulife failed to properly disclose the risks associated with its variable annuities and segregated funds business. Manulife shares took a 12% nose dive on that little bit of news. Then, in what the company has asserted is a pure coincidence, it announced the sudden departure of its longtime CFO.

Industry-Wide IssuesWhile all this has naturally been a bit unsettling to Manulife stockholders, fears that variable annuities could well be an industry-wide problem prompted some selling in the shares of other providers of these products, such as Hatford Financial (NYSE:HIG), Prudential (NYSE:PRU) and Lincoln National (NYSE:LNC). Last May, Hartford, a market leader in variable annuities, made the surprise decision to suspend writing any new variable annuity business in Japan and the UK, and cancelled plans to begin selling these products in Germany.

If there is a problem with this business, what could it be?

For the annuity sellers, like Manulife, there's always been a degree of risk in taking money from annuity buyers, investing it in stocks, and hoping that the future value of that stock portfolio would exceed the annuity liabilities in future years. The risk was manageable if equity markets could be relied on to generally maintain their upward trajectory without encountering a major sell-off. Hedging against such an outcome was another way to control the risk, but it would also cut into profits.

Manulife's Losing Stock Market BetsIn the case of Manulife, the company chose not to hedge the portfolio backing its variable annuity book, and the stock market crash has opened up a sizable deficit on the company's books. At the end of March, its liability to its annuity customers totalled $103.7 billion, but it only had $74 billion in its portfolio backing the business. The company has put aside additional reserves and capital to the tune of $13.4 billion to close the gap, but it now looks like it may have to pony up some more cash. And that could prompt further dilutive stock issues despite the company's stated reluctance to go down that path. Last December, the company had to raise about $2 billion in additional common equity to shore up its balance sheet. Already, analysts have been slashing their per share earnings estimates, both to account for the hit to net income such additional reserve allocations would entail, and the dilute effect of another share issue.The Bottom LineWhile the unfortunate example of American International Group (NYSE:AIG) demonstrates what can happen to a global international insurance giant if it's caught on the wrong side of a market bet, the magnitude of Manulife's exposure here is dramatically lower and therefore much less damaging. Next quarter's earnings per share are likely to be less than half of earlier expectations. Longer term, the new CFO is likely to act with greater prudence than his predecessor, implementing changes to the capital structure of the firm that are likely to shave a few points of the company's future return on equity. All this suggests the stock will still fall further. (For a related reading on insurance, take a look at Top 10 Life Insurance Myths.)